Musings on Naked Puts in Retirement Accounts (Part 2)

Today I want to continue the comparison between vertical spreads and naked puts (NP) to better understand the pros/cons when traded in retirement accounts.

Employing leverage makes for a more compelling IRA strategy but a very clear and present danger exists. Look at the graph shown in the previous post. At expiration, a 100% loss on the vertical spread will be incurred if the market falls to 419. The naked put, in this case, will have lost no more than (497 – 419) / 497 * 100% = 16%.

Market crash scenarios must therefore be considered. Throughout history, the market has periodically incurred drops equal to or greater than the magnitude just described. I must limit position size as an attempt to prevent total spread risk from striking too damaging a psychological blow to my total net worth in case this should occur.

Wrapping my brain around the concept of leverage has been challenging. In the first blog post hyperlinked above, I wrote:

> Suppose I sell a 1000 put for $3.00 and buy a 500 put
> for $0.30. I have sacrificed 10% of my potential return
> to halve my risk. If I traded two of these spreads then
> I have similar risk to the single naked 1000 put and my
> potential profit is $2.70 * 2 = $5.40 instead of $3.00.

The italicized clause is correct: risk in either case is roughly $1,000 * $100/contract = $100,000. However, the market must crash to zero for the NP to realize max loss. The market must only drop to 500 for max loss to be realized on the vertical spread. This is extremely rare but think back to the 2008 financial crisis for a point of reference.

In Part 1 of the link hypertexted above, I wrote:

> A leveraged account can go to zero long before the
> underlying assets do.

Leverage is dangerous because losses are magnified when the market moves against me. This is the flip side of what makes leverage attractive: lowering the cost to enter a position.

The vertical spread is like a NP on steroids. While total risk is decreased (assuming constant position size), the probability of losing everything at risk is increased. For this reason and because a NP qualifies under the “unlimited risk” umbrella, my instincts recommend limiting portfolio allocation for these short premium strategies to 20%.

I think the vertical spread can offer one additional benefit in case of that dreaded market crash. This I will cover next time.